Advanced Search
MyIDEAS: Login

Retesting the CCAPM Euler equations

Contents:

Author Info

  • Samih Azar
Registered author(s):

    Abstract

    Purpose – This paper seeks to reconsider the Euler equation of the Consumption Capital Asset Pricing Model (CCAPM), to derive a regression-based model to test it, and to present evidence that the model is consistent with reasonable values for the coefficient of relative risk aversion (CRRA). This runs contrary to the findings of the literature on the equity premium puzzle, but is in agreement with the literature that estimates the CRRA for the purpose of computing the social discount rate, and is in line with the research on labor supply. Tests based on General Method of Moments (GMM) for the same sample produce results that are extremely disparate and unstable. The paper aims to check and find support for the robustness of the regression-based tests. Habit formation models are also to be evaluated with regression-based and GMM tests. However, the validity of the regression-based models depends critically on their functional forms. Design/methodology/approach – The paper presents empirical evidence that the conventional use of GMM fails because of four pathological features of GMM that are referred to under the general caption of “weak identification”. In addition to GMM, the paper employs linear regression analysis to test the CCAPM, and it is found that the regression residuals follow well-behaved distributional properties, making valid all statistical inferences, while GMM estimates are highly unstable. Findings – Four unexpected findings are reported. The first is that the regression-based models are consistent with reasonable values for the CRRA, i.e. estimates that are below 4. The second is that the regression-based tests are robust, while the GMM-based tests are not. The third is that regression-based tests with habit formation depend crucially on the specification of the model. The fourth is that there is evidence that market stock returns are sensitive to both consumption and dividends. The author calls the latter “extra sensitivity of market stock returns”, and it is described as a new puzzle. Originality/value – The regression-based models of the CCAPM Euler equation are novel. The comparison between GMM and regression-based models for the same sample is original. The regression-based models with habit formation are new. The equity premium puzzle disappears because the estimates of the CRRA are reasonable. But another puzzle is documented, which is the “extra sensitivity of market stock returns” to consumption and dividends together.

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://www.emeraldinsight.com/journals.htm?issn=1743-9132&volume=7&issue=4&articleid=1950994&show=abstract
    Download Restriction: Cannot be freely downloaded

    As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

    Bibliographic Info

    Article provided by Emerald Group Publishing in its journal International Journal of Managerial Finance.

    Volume (Year): 7 (2011)
    Issue (Month): 4 (September)
    Pages: 324-346

    as in new window
    Handle: RePEc:eme:ijmfpp:v:7:y:2011:i:4:p:324-346

    Contact details of provider:
    Web page: http://www.emeraldinsight.com

    Order Information:
    Postal: Emerald Group Publishing, Howard House, Wagon Lane, Bingley, BD16 1WA, UK
    Email:
    Web: http://www.emeraldinsight.com/ijmf.htm

    Related research

    Keywords: Asset pricing; Bootstrapping; Euler equations; Habit formation; Monte Carlo simulation; Real aggregate dividends; Real consumption per capita on non-durables; Real stock market returns; Risk aversion; Shiller's US data; United States of America;

    Find related papers by JEL classification:

    References

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
    as in new window
    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Stuart Hyde & Mohamed Sherif, 2005. "Don't break the habit: structural stability tests of consumption asset pricing models in the UK," Applied Economics Letters, Taylor & Francis Journals, vol. 12(5), pages 289-296.
    3. Jonathan A. Parker, 2003. "Consumption Risk and Expected Stock Returns," American Economic Review, American Economic Association, vol. 93(2), pages 376-382, May.
    4. David Evans & Haluk Sezer, 2004. "Social discount rates for six major countries," Applied Economics Letters, Taylor & Francis Journals, vol. 11(9), pages 557-560.
    5. David Evans, 2004. "A social discount rate for France," Applied Economics Letters, Taylor & Francis Journals, vol. 11(13), pages 803-808.
    6. Breeden, Douglas T., 1979. "An intertemporal asset pricing model with stochastic consumption and investment opportunities," Journal of Financial Economics, Elsevier, vol. 7(3), pages 265-296, September.
    7. Edward C. Prescott, 1986. "Theory ahead of business cycle measurement," Staff Report 102, Federal Reserve Bank of Minneapolis.
    8. Abel, Andrew B., 1999. "Risk premia and term premia in general equilibrium," Journal of Monetary Economics, Elsevier, vol. 43(1), pages 3-33, February.
    9. Spencer, Peter D., 2000. "The Structure and Regulation of Financial Markets," OUP Catalogue, Oxford University Press, number 9780198776109.
    10. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
    11. Raj Chetty, 2003. "A New Method of Estimating Risk Aversion," NBER Working Papers 9988, National Bureau of Economic Research, Inc.
    12. Andrews, Donald W K & Ploberger, Werner, 1994. "Optimal Tests When a Nuisance Parameter Is Present Only under the Alternative," Econometrica, Econometric Society, vol. 62(6), pages 1383-1414, November.
    13. John Y. Campbell & John H. Cochrane, 1999. "Explaining the Poor Performance of Consumption-Based Asset Pricing Models," NBER Working Papers 7237, National Bureau of Economic Research, Inc.
    14. Godfrey, Leslie G, 1978. "Testing against General Autoregressive and Moving Average Error Models When the Regressors Include Lagged Dependent Variables," Econometrica, Econometric Society, vol. 46(6), pages 1293-1301, November.
    15. Donald W.K. Andrews, 1990. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Cowles Foundation Discussion Papers 943, Cowles Foundation for Research in Economics, Yale University.
    16. Yogo, Motohiro, 2008. "Asset Prices Under Habit Formation and Reference-Dependent Preferences," Journal of Business & Economic Statistics, American Statistical Association, vol. 26, pages 131-143, April.
    17. David Evans, 2004. "The elevated status of the elasticity of marginal utility of consumption," Applied Economics Letters, Taylor & Francis Journals, vol. 11(7), pages 443-447.
    18. Hagiwara, May & Herce, Miguel A, 1997. "Risk Aversion and Stock Price Sensitivity to Dividends," American Economic Review, American Economic Association, vol. 87(4), pages 738-45, September.
    19. Davidson, Russell & MacKinnon, James G., 1993. "Estimation and Inference in Econometrics," OUP Catalogue, Oxford University Press, number 9780195060119.
    20. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
    21. Karl-Heinz Todter, 2008. "Estimating the uncertainty of relative risk aversion," Applied Financial Economics Letters, Taylor and Francis Journals, vol. 4(1), pages 25-27.
    22. Atsushi Maki & Tadashi Sonoda, 2002. "A solution to the equity premium and riskfree rate puzzles: an empirical investigation using Japanese data," Applied Financial Economics, Taylor & Francis Journals, vol. 12(8), pages 601-612.
    23. Breusch, T S, 1978. "Testing for Autocorrelation in Dynamic Linear Models," Australian Economic Papers, Wiley Blackwell, vol. 17(31), pages 334-55, December.
    24. Samih Antoine Azar, 2000. "Another look at the rationality of the stock market," Applied Economics Letters, Taylor & Francis Journals, vol. 7(2), pages 87-89.
    25. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
    26. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
    27. Dumas, Bernard & Solnik, Bruno, 1995. " The World Price of Foreign Exchange Risk," Journal of Finance, American Finance Association, vol. 50(2), pages 445-79, June.
    Full references (including those not matched with items on IDEAS)

    Citations

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:eme:ijmfpp:v:7:y:2011:i:4:p:324-346. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Louise Lister).

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.